Title: Midyear Credit Outlook: Slowdown in Europe

Summary

Midyear Credit Outlook: Slowdown in Europe

Podcast: Thoughts on the Market
Host/Author: Morgan Stanley
Release Date: June 12, 2025

Morgan Stanley's "Thoughts on the Market" podcast features a detailed discussion between Andrew Sheets, Head of Corporate Credit Research, and Aaron Becker, Head of European Credit Strategy. In this episode titled "Midyear Credit Outlook: Slowdown in Europe," the hosts delve into the current state and future prospects of the European credit market, providing valuable insights for investors.

Economic Backdrop in Europe

Aaron Becker begins by outlining the challenging growth expectations for Europe. Despite a strong start to the year, growth is anticipated to slow in the latter half of 2025. He highlights the delayed impact of the German fiscal package announced earlier, which won't significantly boost growth until 2026. Becker states:

"Our economists are expecting growth after a fairly strong start to slow down in the back half of this year." [00:52]

He emphasizes the interconnectedness of European and US economies, noting that nearly a quarter of European companies generate revenues in the US. Additionally, US companies are major players in the European corporate bond markets, holding the largest share of bonds in euro benchmarks. This global perspective is crucial as both Europe and the US are forecasted to experience growth deceleration to below 1% over the next 12 months, contrasting with current credit valuations that imply a growth rate of around 3%.

Credit Spreads Amid Economic Challenges

Andrew Sheets raises an important question about the apparent contradiction between slowing economic growth and tight credit spreads, especially in the investment-grade sector. Despite macroeconomic challenges, Morgan Stanley's forecasts suggest that credit spreads remain relatively narrow.

Aaron Becker explains that several factors contribute to this optimistic outlook:

1. Inflation Deceleration: Unlike the US, Europe is expected to see a more significant reduction in inflation over the coming year.
2. Monetary Policy Easing: The European Central Bank (ECB) and the Bank of England are anticipated to continue easing policies, fostering economic stability and increasing demand for credit products.
3. Attractive Yields: Corporate credit yields in Europe are currently appealing, offering better returns compared to cash alternatives.

"We do think that the ECB and the Bank of England will continue to ease policy that's good for the economy and the eventual rebound." [02:58]

Comparing Current Dynamics to Previous Years

When comparing the current environment to the previous year, Becker notes similarities and differences that influence investor strategies:

• Similarities: The attractiveness of credit yields remains unchanged, offering a carry of approximately 3-3.5% on investment-grade corporate bonds.

  "If you just think about credit as a carry product, you're still getting around between 3, 3.5% on an IG corporate bond today." [04:09]

• Differences: Significant policy shifts have occurred, such as the ECB lowering front-end rates by 200 basis points and a steepening yield curve, which is now at its steepest in two years. This steepening allows investors to benefit from both high carry and roll-down on the yield curve, potentially leading to total returns that surpass those of the past year and approach levels seen during the 2022 LDI crisis.

  "If you aggregate the two figures in terms of your expected total return, credit offers actually total returns much higher than over the past 12 months and closer to where we were in the LDI crisis in 2022." [04:09]

Corporate vs. Government Borrowing

The discussion shifts to the contrasting borrowing trends between European corporations and governments. While governments, particularly Germany and the US, are projected to increase borrowing due to expansive fiscal policies, European companies have remained active in the corporate bond markets.

Becker clarifies that the record issuance of corporate bonds, exemplified by May's highest supply levels, should not be viewed negatively. Instead, it offers new issue premiums and enhances market liquidity, benefiting investors. Importantly, despite the increased gross issuance, net supply is expected to decrease due to a significant rise in bond redemptions (up by nearly 20% compared to the previous year).

"Even though we are projecting this year to be a record year for gross issuance from investment grade companies, we think net supply will be lower year on year as a result of those elevated maturities." [07:37]

This creates a favorable technical backdrop for investors, contrasting sharply with the sovereign market's current challenges.

Investment Strategies in European Credit

Aaron Becker offers strategic recommendations for investors navigating the European credit landscape:

1. Selective Risk Exposure: While opportunities are abundant, investors should be discerning in their risk allocations.

2. Extended Duration: Contrary to consensus, Morgan Stanley advises extending duration further out the yield curve. The current steepening curves offer attractive carry and roll-down benefits.

   "We are quite out of consensus on here at Morgan Stanley is our recommendation in European credit to extend duration further out the curve." [08:05]

3. Valuation and Yield Dynamics: High valuations, limited supply in long-dated bonds, and favorable yield dynamics make corporate bonds a compelling choice.

4. Convexity Benefits: Low cash prices in investment-grade credit enhance risk mitigation, as entering bonds at lower prices can reduce potential losses in adverse credit scenarios.

"Cash prices further out the curve are very low in investment grade credit. That tends to be actually quite attractive because then even if you get the name wrong... your loss given default may be more muted if you entered the bond at a lower cash price." [08:05]

Conclusion

The episode concludes with Aaron Becker emphasizing the multitude of opportunities within the European credit market, provided investors adopt a strategic and selective approach. By leveraging favorable yield curves, understanding the interplay between corporate and government borrowing, and capitalizing on the current economic policies, investors can navigate the challenges and harness the potential of European credit in a slowing growth environment.

Key Takeaways

• Slowing Growth: Both Europe and the US are expected to see growth decelerate below 1% in the next 12 months.
• Attractive Credit Yields: Despite economic challenges, European investment-grade corporate bonds offer appealing yields and potential for higher total returns.
• Increased Corporate Issuance: Record levels of corporate bond issuance enhance market liquidity and provide new investment opportunities.
• Strategic Duration Extension: Extending bond durations can capitalize on steepening yield curves and favorable roll-down dynamics.
• Risk Management: Low cash prices in long-dated bonds offer protective benefits against potential credit defaults.

Investors looking to engage with the European credit market should consider these insights to make informed decisions and optimize their investment strategies in a complex economic landscape.

References

• Timestamped Quotes:
  • [00:52] Aaron Becker on European growth expectations
  • [02:58] Aaron Becker on factors influencing credit spreads
  • [04:09] Comparison of current dynamics to the previous year
  • [07:37] Discussion on net issuance vs. redemption
  • [08:05] Investment strategies and extended duration recommendation

Disclaimer

The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.

Transcript

[Andrew Sheets]

Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley.

[Aaron Becker]

And I'm Aaron Becker, head of European Credit Strategy.

[Andrew Sheets]

And today on the program, we're continuing a series of conversations covering the outlook for credit around the world. Morgan Stanley has recently updated its forecast for the next 12 months and here we're going to bring you the latest views on what matters for European Credit. It's Thursday, June 12th at at 2pm in London. So Aaron, it's great to have this conversation with you. Today we're going to be talking about the European credit outlook. We talked with our colleague Vishwas in the other week about the US Credit outlook. But let's really dive into Europe and how that looks from the perspective of a credit investor. And maybe the place to start is from your perspective. How do you see the economic backdrop in Europe and what do you think that means for credit?

[Aaron Becker]

Right. So on the European side, our growth expectations remain somewhat more challenging. Our economists are expecting growth after a fairly strong start to slow down in the back half of this year. The German fiscal package that was announced earlier this year will take time to lift growth further out in 2026. So in the near term we see a softening backdrop for the domestic economy. But I think what's important to emphasize here is that US Growth, as Vishwas and you have talked about last time around, is also set to decelerate on our economists forecasts more meaningfully. And that matters for Europe. Two reasons why I think the US Growth outlook matters for European credit. One, nearly a quarter of European companies revenues are generated in the US and two, US Companies themselves have been very actively tapping the European corporate bond markets. And in fact, if you look at the outstanding notion of bonds in the euro benchmarks, the largest country by far is U.S. issuers. And so I do think that we need to think about the outlook on the macro side more in a global perspective. When we think about the outlook for European credit and if we look at history, what we can deduct from the simple correlation between growth and credit spreads is current credit valuations imply growth would be around 3%. And that's a stark contrast to our economist's forecast where Both Europe and US is decelerating to below 1% over the next 12 months.

[Andrew Sheets]

But Aaron, you talked about the slow growth here in Europe. You talked about a slower growth picture in the US you talked about pretty extensive exposure of European companies into the US Story, all of which sound like pretty challenging things. And yet, you know, if one looks at Your forecasts for credit spreads, we think they remain relatively tight, especially in investment grade. So how does one square that? What's driving what might look like kind of a more optimistic forecast picture despite those macro challenges?

[Aaron Becker]

Right. That's a very important question. I think that it's not all about the growth and there are a number of factors that I think can alleviate the pressures from the macro side. The first is that unlike in the US In Europe we are expecting inflation to decelerate more meaningfully over the coming year. And we do think that the ECB and the bank of England will continue to ease policy that's good for the economy and the eventual rebound. And we also think that it's good for demand for credit products, for yield buyers, where the cash alternative is getting less and less compelling. I think they will see yields on corporate credit but much more attractive. And I do think that credit yields right now in Europe are actually quite attractive.

[Andrew Sheets]

So, Aaron, another question I had is if you think about some of those dynamics, the fact that interest rates are above where they've been over the last 10 years, you think about a growth environment in Europe, which is it's not a recession, but growth is kind of 1% or a little bit below. I mean, in some ways this is very similar to the dynamic we had last year. So what do you think is similar and what do you think is different in terms of how investors should think about, say the next 12 months versus where we've been?

[Aaron Becker]

Right. So what's really similar is, for example, the yield, like I just mentioned, I think the yield is attractive. That hasn't really changed over the past 12 months. If you just think about credit as a carry product, you're still getting around between 3, 3.5% on an IG corporate bond today. What's really different is that over the same period, the ECB has already lowered front end rates by 200 basis points. And at the same time, if you think about the fiscal developments in Germany or broader rates dynamics, we've seen a sharp steepening of yield curves. And curves are actually at the steepest levels in two years now. And what this leaves us with is not only high carry from the yield on corporate bonds, but also investors are now rolling down on a much steeper curve if they buy bonds today, especially further out the curve. So by our estimate, if you aggregate the two figures in terms of your expected total return, credit offers actually total returns much higher than over the past 12 months and closer to where we were in the LDI crisis in 2022.

[Andrew Sheets]

So, Aaron, another development I wanted to ask you about is if you look at our forecasts for the year ahead, our global forecasts, one theme is that on the government side, there's projected to be a lot more borrowing. There's more borrowing in Germany and then there's more borrow the US Especially under certain versions of the current budget proposals being debated. So it does seem like you have this contrast between more borrowing, kind of a worsening fiscal picture in governments, a better fiscal picture among corporates. We talk about the spread. The spread is the difference between that corporate and government borrowing. So I guess looking forward, first, do you think European companies are going to be borrowing more money and certainly more money on a relative incremental basis at these yield levels, which are higher than what they're used to to in the past. And secondly, how do you think about the relative valuation of European credit versus some of the sovereign issuers in Europe, which is often a debate that we'll have with investors?

[Aaron Becker]

Big picture, we have seen companies be very active in tapping the corporate bond markets. This year we had a record issuance in May in terms of supply. Now I would push back on the view that that's negative for investors and expectations for spreads to widen as a for a number of reasons. One is a lot of gross issuance tends to be good for investors who want to pick up some new issue premiums, as these new bonds do come a little bit cheap to what's out there in terms of available secondary bonds. And second, it creates a lot of liquidity for investors to actually deploy capital when they do want to enter the bond market to invest. And what we really need to remember here is all this strong issuance activity is coming against very high maturing volumes of bonds. Redemptions this year are rising by close to 20% versus last year. And so even though we are projecting this year to be a record year for gross issuance from investment grade companies, we think net supply will be lower year on year as a result of those elevated maturities. So overall, I think that's going to be a fairly positive technical backdrop. And as you alluded to it, that's a stark contrast to what the sovereign market is facing at the moment.

[Andrew Sheets]

So on that net basis, on the amount that they're issuing relative to what they're paying back, that actually is probably looking lower than last year on your numbers.

[Aaron Becker]

Exactly.

[Andrew Sheets]

Finally, Aaron, we've talked a bit about the market dynamics, we've talked about the economic backdrop, we've talked about the issuance backdrop. Where does this leave your thoughts for investors? What do you think looks most attractive for those who are looking at the European credit space?

[Aaron Becker]

Opportunities are abound, but I think you need to be quite selective of where to actually increase your risk exposure. In my view. One part which we are quite out of consensus on here at Morgan Stanley is our recommendation in European credit to extend duration further out the curve. This goes back to the point I made earlier that curves are very steep and a lot of that carry and roll down that I think look particularly attractive. You do need to extend duration for that, but there are a number of reasons why I think that that type of trade can work in this backdrop. For one, like I said, valuations are attractive. Two I also think that from an issuer perspective it is expensive to tap very long dated bonds now because of that yield dynamic and I don't necessarily see a lot of supply coming through further out the curve. 3 Our rates team do expect curves to bull steepen on the rate side and historically that has tended to favor excess returns further out the curve. And fourth is a word we love to throw around convexity. Cash prices further out the curve are very low in investment grade credit. That tends to be actually quite attractive because then even if you get the name wrong, for example, and there are some credit challenges down the line for some of these issuers, your loss given default may be more muted if you entered the bond at a lower cash price.

[Andrew Sheets]

Aaron, thanks for taking the time to talk. Thanks Andrew, and to our listeners. Thank you for sharing a few minutes of your day with us. If you enjoy the show, leave us A Review Wherever you listen to this podcast and share thoughts of the market with a friend or colleague today, the.

[C]

Preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.